*Disclaimer* The team member who wrote this article is not a mortgage broker or lender and this information is for entertainment purposes only. Always discuss your personal situation with a licensed loan officer before making any decision to get or adjust your mortgage.
What is mortgage insurance?
Mortgage insurance is an insurance policy that, as a borrower, you are required to pay if your property is highly leveraged– typically if your down payment is less than 20%. Contrary to popular belief, the insurance policy actually protects the lender in the event of your default, not you.
For example, let’s say you just bought your dream home for $400,000 with an FHA loan. Your down payment was $14,000 (3.5% of the purchase price) and your initial mortgage amount was $386,000. You move into the house, spend your first few months there, and are loving life.
Six months into your loan, you lose your high-paying job and can’t find another one despite how hard you try. The market changes and the value of your house falls 5%. You can’t afford the house anymore so you move back in with your parents, stop making payments, and cut your losses. It’s not that big of a loss, right? You only put $14,000 in the first place so you don’t have a lot invested in the property. The lender calls you one day and tells you they are going to start the foreclosure and you tell them you can’t afford the house anymore and can’t refinance it because the value is too low.
The lender looks at your file and realizes the unfortunate truth. Your house is now worth $380,000 (on a good day), the loan balance and fees you owe them are now $390,000, and if they take the house back they are facing losses upwards of $80,000 on your loan. Why so much? The foreclosure process is going to take 6-12 months (or much longer in some states), the lender’s legal fees are going to be enormous, the realtor they hire to sell the house has to get paid, and by the time they take the house back any number of things can happen (deterioration, break-ins, etc.) that will lower its value.
Some version of this situation happens thousands of times across the world every month and this is the risk that lenders take making loans.
In this case though, your lender will not lose any money. Why? Because your FHA loan includes a mortgage insurance policy that you paid for up front at closing (and monthly while you were making payments). This means that the lender is going to be made whole by either the government (for FHA and USDA loans) or another financial institution (for conventional loans).
That’s how mortgage insurance works.
What are some important things to know about how it all works?
1 – For government-insured loans (FHA, VA, USDA) your mortgage insurance will never go away. You must refinance or pay off the loan to make it disappear. For conventional loans, your mortgage insurance will disappear after a certain amount of payments – generally once your loan is paid down to less than 78% of the value of your home.
2 – Mortgage insurance, like any other insurance, varies widely in cost. Your credit score, debt to income ratio, property type (single family, multifamily, mixed use, etc.) can all dramatically change this number. Two people could be buying the exact same house and borrowing the exact same amount of money, but one person with a lower credit score applying for an FHA loan could be paying nearly triple the amount for their insurance than a higher credit score borrower applying for a conventional loan with strong income.
3 – Mortgage insurance can be bought out. You always have the option to buy out the insurance policy up front. Generally the cost to do this is not worth it which is why most lenders won’t suggest it, but in some cases you may need to do so for there may be other benefits. For example, if your mortgage insurance is $300/mo. and that pushes your debt-to-income ratio into a bracket that causes you to have a higher interest rate, it may be worth considering putting extra money down to pay it off up front if you have it.
4 – Mortgage insurance can be removed any time if you can prove to the lender that you have 20+% equity. This generally must be done through an appraisal report that you must order through the lender. If you think your house has appreciated significantly, it’s often worth risking $500 or $600 for an appraisal report to get the payments removed.
5 – There are alternatives to mortgage insurance. Many lenders offer products such as second mortgages to increase your loan amount without you paying for the extra insurance. Similar to point #2, you should discuss the options with your lender and weigh the cost vs. benefit of each scenario. Sometimes getting a second mortgage is a great option.
When you’re shopping for a mortgage, knowing what questions to ask is more than half the battle. The other half of the battle is choosing the right lender because they are NOT all created equal! There are dozens of details and strategies/planning that lenders implement behind the scenes to get your loan to closing smoothly that you’ll never hear about as the consumer. So shop carefully!
Rodney Ross
June 7, 2022